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Are market rates below the natural rate again?

April 9, 2011

by Andreas Hoffmann and Mario Rizzo

We know from Wicksell’s (1898) Interest and Prices, there is something important about the interest rate that balances saving and investment in an economy over time. This equilibrium interest rate is called the “natural rate of interest”. When market interest rates are below the natural rate, an unsustainable credit boom which distorts the production structure in the economy and inflation are the result.

In line with this idea, most economists agree – today – that the Fed held interest rates “too low for too long” following the burst of the dot-com bubble. As expected, this contributed to a credit boom in the US economy. With the emergence of the crisis, the Fed lowered interest rates to stabilize the price level, financial system and output. Yet, a year of recovery is over and interest rates are still low. What about the natural rate today?

Admittedly, it is hard to find a reliable number for the natural rate. In the end, it is a market rate that is hard to know. Throughout the literature the concept is used in variations. The rate reflects time preferences of market participants and allocates resources efficiently (See Garrison). Some refer to it as the average period of production (hard to measure). Since it is the rate at which money supply is neutral – thus it creates no distortions and no inflation – in Wicksell’s and Hayek’s frameworks, it can also be seen as something close to the equilibrium rate that comes out of a Taylor rule.

Laubach and Williams (2003) provide an estimate for the natural rate. It is on average 3.2 percent. Since this was in 2003 and the natural rate has a downward-trend in their paper, the rate may be lower today. Laubach and Williams show that the natural rate is strongly related to output growth and falls in times of crisis. It is not stable. Thus, during a crisis as in 2001 the natural rate was 1 percent, while it is was at 5 percent in the previous boom.

To hold market rates close to the natural rate, the Fed has to lower interest rates during the crisis and raise them in the boom. Hence, stabilizing the market rate at the level of the natural rate is similar to stabilizing Fisher’s real rate. When we want to stabilize the real rate we have to adjust the nominal interest rate by the expected inflation rate (plus the cross product). But now, we want to hold the real rate at the level of the natural rate. Thus, when the natural rate falls, the real rate we aim at has to fall, too. From this perspective, it was probably correct to lower rates during the turmoil.

But what about today?

First some data: Since the natural rate seems to be closely related to the average real growth rate, we calculated an average of the growth rate from 2000 to 2011. It is 2.5 percent. This is close to the Laubach and Williams measure (3.2 percent – X) and therefore sufficient for an argument in a blog post. We assume 2.5 percent to be the average real natural rate of interest. Further, expected US inflation for 2011 is about 2.6 percent. This is an average of four indicators to estimate future inflation between 1.6 and 4 percent (WES, WEO, Michigan consumer expectations, current inflation). The nominal fed funds rate is currently at 0.25 percent.

A quick shot analysis: The real policy rates are about negative 2 percent. Many commentators argue that this is not problematic since banks do not lend freely due to risk aversion that stems from the latest crisis experience. However, this rate already translates into 1.8 percent real rates on mortgages and 0.8 percent real interest rates on car loans (BOA: March 2011, We simply subtracted expected inflation of 2.6 percent). Hence, the average credit rate is below the average long-run natural rate of 2.5 percent.

As the economy grew above trend last year and is expected to grow by 2.5 percent this year, from the arguments above, it would be odd to assume that the natural rate is currently below its long-run trend. Banks already pass on low central bank rates to customers. If the risk appetite of banks increases, credit supply will rise and credit rates will fall even further below the natural rate, given the cheap refinancing costs. Thus, nominal policy interest rates are too low and have to be raised to prevent another unsustainable credit boom and inflation. But central bankers seem to hesitate to do so – perhaps – for political reasons.

19 Responses to “Are market rates below the natural rate again?”

Since the natural rate is the one determined by market forces and are undistorted by Fed or other government interference, all of this sounds like the same kind of rational calculation of prices central planners were supposed to be able to engage in, but in fact never could. Forgive me, but isn’t this pretty much wild guessing, but with math? I know we have to deal with the situation as we have it, which is one with a Fed, which we would hope to advise to do better than they have, but in the end it’s unlikely we’re guessing right, it’s likely that the natural rate changes over time (and space), and whatever we recommend will either be too high or too low — which of course will change due to the problem of time and space.

If we view the natural rate of interest as the intertemporal price at which present goods trade for future goods, which itself is ultimately based on the time-valuations and preferences of market participants concerning consumption closer to the present vs further in the future, I find it hard to see how we can determine what the natural rate is or should be independent of allowing the market to “discover” it through the process of competition.

Now, it is precisely because the monetary authority can “falsify” this pricing process through monetary expansion (or contraction) that some economists, an certainly including the “Austrians,” are doubtful and critical of monetary “activism” at various stages of the business cycle.

This is certainly true at the start of a business cycle, because the Austrians would consider such monetary meddling to the general cause that sets the business cycle in motion.

But this is no less the case once the bubbles have burst and the recession phase of the business cycle sets in — which, in “Austrian” eyes, is the readjustment, or “recalculation” period during which the markets discovers the mis-allocations, mal-investments, and distortions of the relative price and wages structures that were generated during the boom phase of the business cycle.

Now, I am well aware of the the arguments that a good number of Austrians have made that the “corrective” phase of the downturn can have superimposed upon it a monetary deflation (not only from an actual contraction of the quantity of money in circulation by the monetary authority) that is due to a change in the demand for money (an increase in the desired average cash balance individuals and businesses wish to hold) caused by new uncertainties and actual or expected losses that result in people wanting to be more “liquid” to weather the storm.

But we must accept the fact that there is no way for even the most benevolent and politically unbiased monetary authority to successfully untangle which falling offs in employment, production, market demands, and changes in prices and wages are the “real” and required ones to bring the market back into balance for longer-term sustainable growth and coordination, and which of these (or to what extent simultaneously with the required “real” adjustments) there are such impacts on the economy due to “only” the temporary desires for greater money holding. And which, in principle, in the pure theory of “neutral money” and a hypothetical “monetary equilibrium” could be counter-balanced by a monetary “accommodation” so possible “secondary” deflationary processes do not occur.

The distinguishing between “variables” and “factors” at work in creating the “composite” outcomes of the market that we can conceptually undertake through our method of “mental experiments” have no (or few) “empirical” counter-parts. Because in the “real world” everything is happening at the same time — the “complex phenomena” to which both Mises and Hayek referred.

And there is always the likely risk that the monetary authority will interrupt and disrupt the readjustment or “recalculation” process, either prolonging it, or preventing it, or setting in motion new “bubbles” that will also have to burst at some point in the future.

The monetary authority cannot sort all this out, and “manage” the supply of money and credit in such a way to get the “natural rate” right as a “support” for the market processes at work.

The monetary authority trying to estimate and adjust its monetary policies to match what the market “natural rate” should be runs the risk of being an instance of Hayek’s warnings about a “pretense of knowledge.”

It is good to see an essay recognizing that the natural interest rate can change. While the problems created by a market rate below the natural rate are worth mentioning, why no mention of the problems caused by the market rate being above the natural rate?

While I can see why the level of the natural rate would be associated with the growth rate of real output, I think the expected future level and growth rate of output will be more important.

For starters, draw an IS curve and put potential output on the horizontal axis. Go up to the IS curve and over to the vertical axis, and there is the natural interest rate. All the things that impact the IS curve (government spending, taxes, consumption, investment, exports, imports) impact the natural interest.

Not that shifts in potential income can impact the natural interest rate as well, though have a care about the impact of future changes.

Now, consider levels of income away from potential income. For example, the level of the real interest rate that keeps saving equal to investment at a level of real income below potential income is going to be above the natural interest rate.

Now draw a supply of saving and demand for
investment diagram. Consider how budget deficits and net capital flows impact saving. Shifts in investment or saving cause changes in the natural interest rate and the allocation of resources (in these broad categories at the very least.)

Consider how expectations of future income and output will impact those curves. It is likely that higher expected income will reduce saving (shift to the left) and raise investment (shift it to the right.) This has little impact on the allocation of resources (in these broad categories, anyway) but will raise the natural interest rate.

So, quite rapid growth rates of current output are consistent with the market rate being above the natural interest rate if that growth is a recovery from a level of output below potential. On the other hand, expectations that a recovery has taken hold, and that output and income will be higher in the future should raise the natural interest rate.

If we assume that output is an potential and higher growth rates are moving potential output to a persistently higher level, and people know this and believe it, then the natural interest rate can be expected to rise.

The natural interest rate is the interest rate that exists without an imbalance between the supply and demand for money. Only if one assumes that monetary disequilibrium can only exist due to some government action would the market rate always equal the natural interest rate without government action. I think both the supply and demand for money can change without government action and gaps can develop, so the market rate can deviate from the natural interest rate for many reasons. There are market forces that slowly correct such deviations. Can a central bank hasten the process consistently? But the nature of the natural interest rate and how it changes is not central to that question.

Similarly, there are many government policies that impact the natural interest rate. For example, tax policies that impact the supply of saving. Is it really reasonable to say that the natural interest rate is the level of the interest rate that would exist if there were no taxes (or some kind of tax that was perfectly neutral regardign saving and investment?)

Consider the gasoline market. The equilibrium price is the price where quantity supplied equals quantity demanded. It isn’t the price that would exist if there we absolutely no government intervention in the oil market (no taxes or subsidies, for example.)

And it isn’t the price that exists with no price controls. There are market forces that move the market price to equilibrium–clear up shortages or surpluses. But the market price may be greater or less than equilibrium, and those processes would then come into play.

A policy issue would be whether or not the government could set the price and adjust it to better clear the market that firms adjusting prices to seek profits.

Of course, with a central bank, it is a bit different, since the “policy rate” is really a market rate, and just a marker of the central banks ability to correct and create monetary disequilibrium by changing the quantity of media of exchange.

As I aleady mentioned, can the manipulation of the quantity of money by the central bank, perhaps watching some market interest rate or other, better correct monetary disequilibrium than the market process across the board adjustments of prices, including wages? That is the policy question. (For free bankers, the relevant quesetion is whether the central bankers can do better than competitive banks in avoiding monetary disequilibirum.)

While I would be very skeptical of a government wheat board adjusting wheat prices to clear the market (and if it is not using price controls but rather accumulating and releasing stocks of wheat, speculating on the market, this comes very close to central banking,) but I think it is nothing like central planning of the economy.

We are not mathematically DERIVING the natural rate. In other words, we are not substituting the economist for the market. We are trying to figure out what the market is saying about this theoretical concept (“the natural rate”) in a world of manipulated interest rates.

Every economist who has ever said that interest rates were too low for too long (or the equivalent) must have a standard in mind. The standard cannot be read directly from the world. It takes some digging. We did a little digging.

I’m sorry I wasn’t clearer, but I didn’t mean to ask whether a natural rate of interest could be “designed”. My question asked whether it’s possible to know what the natural rate of interest actually is, especially as it changes (so, when I say derive, I mean derived from market data).

Btw, when economists say that “interest rates are too low” I don’t think they have a specific standard in mind. When the Federal Reserve enacts monetary policies which push interest rates down I think it’s usually assumed that the rate of interest is “too low”; I don’t think anybody pretends to believe to know where exactly the rate of interest should be.

Of course, you would be absolutely right to argue that assuming monetary disequilibrium it could be that the market rate of interest is actually higher than the natural rate of interest, but let’s be real, during booming economic times I really don’t think that’s the issue.

Anyways, what’s the difference between regulating the money supply by gauging velocity and trying to regulate the market rate of interest with some supposed natural rate of interest that was somehow extrapolated from market data? It seems to me that there’s better ways to reduce the amount of distortion caused by the Federal Reserve.

“When the Federal Reserve enacts monetary policies which push interest rates down I think it’s usually assumed that the rate of interest is “too low”; I don’t think anybody pretends to believe to know where exactly the rate of interest should be.”

This does not make much sense to me.

You cannot argue the central bank artificially held interest rates below the natural rate – which caused an ABC – if you do not think the natural rate is somehow higher than the policy rate.

Given that there are central banks, Mario’s first comment applies. It is necessary to get a grasp of where the natural rate would be.

In response to Mario’s reasonable point that in a world with central banking, there should be a policy to minimize the damage that the monetary authority might generate.

One answer: stop increasing the money supply (the monetary base), or attempting to use changes in the monetary base to determine other monetary aggregates considered to be relevant to “hitting” other macro-aggregate targets.

A free, competitive private banking system might very well adjust its outstanding note and deposit liabilities to accommodate preferred cash balance holdings of their clients. And an unintended consequence might be degree of changes in the money supplies to match changes in demands to hold money substitutes.

But a monetary central planner still suffers from the same limits of all central planners, and cannot do equal to or better than a private competitive market “solution.”

But notice the words I chose to use, above. Private competitive banks might adjust their money supplies — I use the plural.

There would be no single — or “the” — money supply in such a free banking system. And no private bank or even group of private banks would have as its business goal stabilizing any economy-wide monetary aggregate. No more than the shoe manufacturers, in adjusting their shoe supplies to changing shoe demands, intentionally “target” a “stable” shoe “price level” to maintain or establish shoe supply and demand “equilibrium.”

Any future goal of monetary freedom, we must accept, will mean the end to monetary policy in any way we currently think about it. There will be no interest rate “targeting” — natural rate or otherwise. No monetary aggregate targeting. And no monetary equilibrium targeting.

You cannot argue the central bank artificially held interest rates below the natural rate – which caused an ABC – if you do not think the natural rate is somehow higher than the policy rate.

I never said otherwise. But, just because you believe the natural rate of interest to be above the current market rate of interest doesn’t mean that you have a specific standard in mine. If the market rate of interest is 1% and you think the natural rate of interest is higher that means the natural rate of interest is somewhere between (1, ∞).

Richard’s remarks seem spot on to me. The claim that the Fed should (and can?) mimic the operation of a free banking system presumes we can transfer the analysis and results of one institutional setting (free banking) to a very different institutional one. The general point is that a central bank cannot ever get it right, if by “right” we mean a free banking system’s operation.
Bill Butos

In regards to Fed policy between 2000-2007, it is questionable whether or not it actually had much impact interest rates. (This isn’t to say it COULDN’T impact rates, just that it likely DIDN’T.)

First, during this time period, the monetary base (the only money stock measure over which the Fed has control) increased by 4% annually. Moreover, if we take into account U.S. currency flowing overseas, this number drops to 1.9%. Not exactly massive growth.

Second, the Fed was a small player in the Treasury market. From 2000-2007, a seven YEAR period, the Fed’s Treasury holdings increased by approximately $250B. However, the average DAILY trading volume in the Treasury market was something like $450B. So the Fed’s net position change over seven years was equal to half a day’s trading volume.

Third, the Fed’s gross daily average trading volume was 2% of the market (by gross I mean sales and purchases, outright transactions and repos). If we look only at outright purchases – which makes sense as the market knows repo transactions net out over a short period of time – the Fed’s role in the Treasury market is something like 0.05% (1/20th of one percent).

The most convincing evidence in my mind, however, is the large volume of foreign government purchases of Treasury securities. From late 2002 to 2007, Federal Reserve Treasury holdings as a percent of marketable Treasury securities outstanding decreased from approximately 20% to 18%. Meanwhile, foreign government holdings (again as a percent of marketable Treasury securities outstanding) increased from approximately 25% to 33%. So who impacted interest rates more, the player whose percent of the market dropped by two percentage points or the one whose share increased by 8 percentage points?

(Note: U.S. government demand for loanable funds is based upon the U.S. budget balance, and most likely not on the price of loanable funds (the interest rates). Similarly, foreign governments often purchase U.S. Treasury securities as a risk-free parking mechanism for their dollars and to control exchange rates. So their supply of funds is arguably price insensitive.)

Thanks to Justin Rietz for his comments, even if late. He raises many points. The big issue is the rise of shadow banking, and we must go back to the 1990s to track its evolution.

Velocity rose way above trend in that decade, peaking in 1997. Financial liabilities were increasingly being created in “nonbank” financial institutions (e.g., investment banks). Treasury securities were leveraged as collateral for carry trades.

The critical issue is that commercial banks were critical to the expansion of shadow banking. If it had wanted to do so, the Fed could have ended the Ponzi scheme at any time. Fed policy was the sustaining cause of the housing boom and bust.

The carry trade resembled the financing of housing and real-estate in the 1980s that ended in the S&L crisis. And the complexities of defining “money,” and distinguishing between money demand and money supply occurred in the 19th century.

To make sure I understand your argument, are you saying that the Fed should have slowed the increase of(or decreased) the monetary base in order to counteract the money multiplier (for M1, M2, MZM, etc.)? And/or are you saying that the Fed should have implemented or enforced other regulations?

Good questions and I have no easy answer. Based on what I have been told, the Fed pretty much ignored the development of shadow banking. Just as it is now ignoring the effects of its monetary policy on the rest of the world.

Shadow banking embodies some genuine financial innovation, and also evasion of banking regulations. Now the investment banks are having it both ways: they have become bank holding companies with access to Fed lending and they continue to operate “in the shadows.” It’s an unstable system.

The relationship between the monetary aggregates and the economy started breaking down in the 1980s. By the 1990s most monetarists had switched to targetting prices or nominal GDP. CPI doesn’t tell the whole price story, however, and following it (or worse, “core” CPI) allowed the Fed to ignore the housing bubble.

Doing monetary policy under a fiat monetary standard is increasingly difficult. Especially so for the producer of the global currency.

I concur that a fiat currency causes difficulties. To channel Jeff Hummel, I think a fiat currency will continue over time to lose value as financial institutions find innovative ways to pyramid on top of their reserves, similar to your description of the shadow banking system (of which my knowledge is admittedly limited).

I wonder, however, if it is fair to blame the Fed for the problems inherent in a fiat system. Greenspan and et. al. came quite close to freezing the monetary base, which is (bear with me) arguably similar to having a “gold standard” under a fiat system, the dollar = gold = high powered money.